What is Accrual Accounting?
As our client base at GrowthLab continues to expand, we have seen an increased amount of clients that use true accrual accounting for their operations. Many of our small business clients use cash accounting, where revenues and expenses are recorded as cash is exchanged. Accrual accounting, however, records revenues and expenses as they are incurred. From a sales reporting perspective, this is important, as a client may not collect on all of their sales as they happen, and they can gain a history and reporting of their sales when they happened, as opposed to when their customer ends up paying. This holds true with businesses that afford their clients terms, and maintain a list of receivables throughout the year. For a retail based business, it would be important for them to know when they expect most of their sales to happen so they can properly house inventory to meet customer needs. For a service based industry, such as a landscaper, maybe it’s best to know to have availability during the spring and fall cleanup times, versus the middle of winter.
By using accrual accounting with expenses, a client is able to better track and plan for expenses on a monthly basis. This also allows a business to properly forecast for their cash flow, if they know to expect certain bills on a monthly basis, and when those bills due dates generally fall. If a client either pays there bills as cash flow allows, on a cash basis client, this will result in a higher expenses in the month(s) when those bills are actually paid. Some of the biggest instances where accrual accounting can make an impact on reporting is rent, utilities, insurance policies and year end reporting. In instances of rent, accrual accounting assures that a rent expense is recorded during each month on the P&L. Accrual accounting would not indicate multiple month’s rent, during one reporting period, if the business had to pay multiple months in advance, or in back rent. Accrual accounting also allows a business to properly forecast their cash flow, if they know to expect certain bills on a monthly basis, and when those bills due dates generally fall.
In the case of utilities (for this we will include gas/oil (heating), electric, and telephone), accrual accounting can be a key indicator in reporting. If a client receives a gas bill in February, it may be a higher bill than the one they receive the following month in March, as the weather warms up and less use of heating is required. That bill is to be recorded as such in February to show a higher gas usage during that month, which is also key for comparative reporting. For a cell phone, perhaps a client goes on a trip and incurs additional charges for data usage, roaming, etc. That bill should be recorded as such to provide the client with a report that can show actual expenses incurred for that time period. Higher level accrual accounting would not just record the bill on the date of the bill, but actually adjust the expense based on the usage dates on those bills.
At year end, accruals can be a very important piece to the clients final bottom line for the year. Clients may receive bills in January, and sometimes later, for expenses incurred in the previous year. Some of the most frequent instances could be repair bills, legal bills, or services bills. Many times you will also see legal bills that come in for services performed in the prior month. As such, those expenses should also be accrued into the prior period. The same types of adjustments would be necessary if a client pre pays for services. This could include paying an insurance policy in full, or putting a deposit on a future purchase, service, or event. In these instances, the proper step would be to post these items through a Prepaid Expense, an asset account, and then to expense at the proper time.
There are many more instances, and examples of how bills would need to be recorded on an accrual basis. It is important to understand though that you cannot simply adjust a bill date to accrue a bill properly. All bills need to be entered for AP control purposes with the actual bill date, and due date, as received on the bill. If the services performed on the bill are for a period before the bill date, proper accrual adjustments would need to be made. The level of details in reporting with accrual accounting can be very detailed, and much more extensive than a simple cash based business. If that business warrants accrual accounting, they can use those reports to make better business decisions and forecasts into the upcoming period.
